What next for GBP after UK inflation surge?

Hi everyone,

 

£-€ rates broke 1.19 mid-market for the first time in 2-weeks during the run up to yesterday's UK inflation release. But the beat on forecast (10.1% vs 9.8%), saw the pair lose 1% during the trading day overall. It was the first bit of volatility seen for over a week after a brief consolidation period and the views on what the inflation number means is mixed.

 

The initial rise in GBP was likely a knee-jerk reaction (as is often seen after important economic data), largely driven by algorithms set by traders. The reason for the dramatic fall after the release is unclear, especially as £ has risen 0.5% across the board today. What it does do is put pressure on the BoE next month to continue to raise interest rates aggressively. This becomes a risk event as if they don't, the Pound will drop like a stone. The chances of this happening are slim though, seeing as inflation is expected to rise to 13% by year-end and so interest rates must go higher.

 

But higher interest rates and rising inflation will slow business and consumer activity. This will weigh on the economy and therefore Sterling. So we have a catch-22 situation. The market will keep £ propped up as long as the UK continue to raise rates to combat high inflation. But, as soon as real economic cracks start to appear, the Pound will fall. 

 

Last month was proof of this happening. The bank hiked aggressively for the first time during this cycle to combat red-hot inflation, but also delivered a harsh economic future for the UK. The market ignored the jump on rates and even the promise by the MPC to hike further near-term and instead sold GBP after recession fears were forecast for all of 2023.

 

Of course this is only one headwind of many involved in the currency market, but this one is prominent and looks negative for the £. 

 
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